Know Your Risks Before You Invest In This 20% Yielding Stock

| About: ARMOUR Residential (ARR)
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ARMOUR Residential (NYSE:ARR) is one of the largely followed Agency-only mREITs. Most of the securities that ARMOUR invests in are backed by single-family home loans, which are fixed-rate in nature. ARR earns interest on these interest yielding assets. These assets are purchased with short-term financing (repos), on which the company has to pay a cost. ARR finally earns a spread between the interest earned and the interest paid. This is ultimately shared with its investors in the form of dividends.

With a market cap of around $1.5 billion, the stock yields a massive 20.4% in dividends. So, now you can imagine why it is one of the largely followed mREITs. However, ARR's year to date performance has been rather unimpressive. Its stock price fell 36% since the beginning of the year owing to the volatility in interest rates since the mid of the first quarter.

Latest earnings summary

Armour Residential reported second quarter GAAP EPS of $1.28 per share, which included unrealized gain on derivatives. Its core EPS came in at $0.18 per share, lower than Barclays estimate of $0.20 per share. The earnings miss was largely attributed to lower asset balances during the quarter. Book value erosion of 19% during the quarter was largely in-line with expectations.

Net interest margin increased 4bps over the prior quarter to 1.39%, which was higher than estimated, mainly due to higher yields on assets. The yield on earning assets in 2Q was 2.53%, up 20bps from the prior quarter. Cost of funds and hedging increased 16bps q/q to 1.14%.

Leverage decreased slightly to 8.9 times from the prior quarter's 9.2 times. Leverage in the month of August was 7.0 times debt to 2Q ending shareholders' equity.

Constant prepayment during 2Q was 10.8%, down from 15.7% in 1Q. The constant prepayment rate in the month of August was 9%, down from 11% in July.

The duration of ARR's agency assets was 5.95 in August. The balance sheet duration net of interest rate swaps and swaptions was 1.

Know your risks

Increases in interest rates and adverse market conditions may negatively affect the value of investments and increase the cost of borrowings, which may result in reduced earnings or losses, reduced cash available for distribution to stockholders and reduce the book value per share.

- The timing and methods in which the U.S. government may extricate itself from its involvement in the agency MBS market is of importance for ARR. Under the QE3, the Fed is buying Agency MBS in order to keep mortgage rates low. However, since the US labor and housing markets continue to give mixed signals, I believe the Fed is not in condition to halt its stimulus efforts. Until then, the volatility in rates will continue, causing ARMOUR Residential to report significant book value erosion coupled with lower shareholder distributions.

- ARR utilizes short-term repo financing which may be less available / or more expensive if MBS prices are volatile and / or a large repo counterparty fails. The company may also be subject to margin calls if agency MBS prices decline significantly.

- The management at ARR also has to manage convexity risk. Mortgage backed securities are negatively convex while swaps are positively convex and may respond differently to changes in interest rates.

- A flattening yield curve could reduce potential spread income on new investments and on unhedged assets. However, the company is not immediately exposed to this risk as the rates are on the rise since the start of the year.

- Higher prepayment rates may negatively affect the value of agency MBS and could result in an asset / liability mismatch. While prepayments usually accelerate during times of declining rates, they can be of some help when the rates are on the rise. Since prepayments arrive before they are due, they can be used to invest in the new production high yielding securities in the prevailing rising rate environment.

Final note

Since the US labor and housing markets continue to give mixed signals, I believe the Fed will decide to prolong its QE, resulting is more volatility in the rates. That's because the Fed will wait until it sees sustainable growth in both markets until it finally decides to pull the plug off. So, until the Fed finally halts the QE and the rates stabilize, I recommend investors stay away from this stock, or they may face capital depreciation that can take years of dividends to offset.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Equity Whisper is a team of analysts. This article was written by our Financials analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.